April 28, 2005

Global Trader's Diary Answers The Bell

I don't really have problem with Fed policy until around Nov 1998 and I think these issues are best addressed by Paul McCulley's more constructive Fed criticism from March of 2000:

Which brings us to the question of whether the interest rate tool is the right exclusive instrument for dealing with the problem. I know of no economic model that postulates a high interest elasticity of demand for lotteries! Virtually every economic model incorporates, however, a high interest elasticity of demand for the goods and services of the Old Economy.

Thus, using the interest rate tool exclusively to thwart wealth creation in New Economy stocks carries grave risks for the Old Economy...

Under Regulation T, the Fed has the authority to set initial margin requirements for the purchase of stocks on credit, which has been at 50% since 1974. The Fed should raise that minimum, and raise it now.

That's an interesting comment. The November 1998 date gets my attention because, well, I don't actually disagree. The record shows that my boss at the time, Jerry Jordan, actually dissented on the rate cut from that meeting on the grounds that it was too much ease:

Mr. Jordan dissented because he believed that the two recent reductions in the Federal funds rate were sufficient responses to the stresses in financial markets that had emerged suddenly in late August. An additional rate reduction risked fueling an unsustainably strong growth rate of domestic demand.

That, in fact, was his fifth dissent of the year. Prior to the rate cut in September that year (following the Russian currency crisis and LTCM debacle), Jerry had been arguing that the best course was to remove what he believed to be an excessively stimulative stance of monetary policy. In his dissents, I saw the same sentiment that was just recently articulated by my current boss:

How, then, should monetary policy deal with current account imbalances today? I do not think that the FOMC should take preemptive measures to address these imbalances. However, I do think that the Committee should continue to bring the federal funds rate target to a level that is consistent with maintaining price stability in the long run. If we achieve that, then we will be in a position of strength to address whatever challenges arise.

It is good to have conversation about whether mistakes have been made, or are being made, in achieving that goal. It is productive to have intelligent critiques of the regulatory practices of the Federal Reserve, and generate discussion on whether those practices contribute to financial stability, or not. (Although I do not generally think of these responsibilities under the heading of "monetary policy" -- they are the province of the Board of Governors, not the Federal Open Market Committee.) I objected to the Roach article because it was not all constructive. The GTD post is.

Michael concludes:

While defending Roach's piece is a bit difficult, I am not that comfortable absolving the Fed either.

Comments

Kwan's conclusion:
"The recent run-up in margin credit has prompted some policymakers to debate the idea of changing margin requirements to stem possible speculative excesses. However, the effectiveness of using margin requirements as a policy tool is questionable. Investors can use financial derivatives to obtain exposure to equities without owning stocks, and they also can substitute margin credit with other types of credit. Finally, the bulk of the research on margin requirements indicates that changes in the requirements do not have a significant permanent effect on the behavior of stock prices."

I still think higher margin requirements would have sent a message. My other recommendations at the time were to reverse certain provisions of the "Private Securities Litigation Reform Act of 1995" that clearly facilitated fraud and to restore funding to the SEC enforcement division (that Congress cut in the mid-90s).

Now I'd suggest tighter credit requirements for home loans. 100+% financing with interest only ARMs is widespread and has led to rational speculation (rational for the speculator, not for the rest of us).

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The GDP Report: We, Apparently, Are Not Pleased

I'm not sure I had ever contemplated what the day would look like when 3.1 percent growth was considered bad news, but now I know for sure. From Bloomberg:

The U.S. economy grew at a 3.1 percent annual pace in the first quarter, the slowest in two years, while inflation accelerated. Inventories swelled as consumers and businesses reined in spending, suggesting cutbacks in production may hinder growth this quarter.

An inflation gauge tracked by the Federal Reserve rose the most since late 2001, today's Commerce Department report in Washington showed. The initial estimate of gross domestic product, the total value of goods and services produced, trailed the 3.5 percent median forecast in a Bloomberg News economist survey...

The personal consumption expenditures price index excluding food and energy, a measure tied to consumer spending and watched by Fed officials, rose at a 2.2 percent annual rate last quarter, the fastest since the fourth quarter of 2001. The rate was 1.7 percent in last year's final three months.

Inflation gauges in the report were mixed. The chain-weighted GDP price index, a measure of economy-wide inflation, increased at a 3.3% rate -- the fastest since an identical jump in the first quarter of 2001-- after rising 2.3% in the fourth quarter. The price index for personal consumption rose at a 2.1% rate after climbing 2.7% in the fourth quarter. The price index for gross domestic purchases, which measures prices paid by U.S. residents, rose at a 3% rate in the first quarter after advancing 2.9% in the fourth quarter.

That dip in the personal consumption expenditure price index was trumped, of course, by the increase in its ex food and energy version.

The experts did not like. From the previously cited Bloomberg report:

"The rise in inventories was an especially unwelcome development,'' said Chris Rupkey, senior financial economist at Bank of Tokyo-Mitsubishi Ltd. in New York. ``If this inventory is not cleared quickly, it will lead to cutbacks at the factory.''

“It is the mix of growth that is the biggest disappointment,” said Paul Ashworth, an analyst at Capital Economics, a consultancy.

“If business investment is slowing, there is nothing to pick up the slack as consumer spending weakens.” A big rise in inventories during the quarter suggested some companies might have been caught by weaker demand, he said.

"The market digested the economic data and wasn't at all pleased that the GDP numbers came in at a lower-than-expected rate," said Gordon Fowler, Jr., chief investment officer at The Glenmede Trust Co. "There's growing concern that this slow patch is going to be longer and deeper than people originally thought, and that's going to have a negative impact on earnings and economic growth over the next few quarters."

"The market's having trouble with the question of how much the economy is going to slow,'' said Scott Wren, senior equity strategist at A.G. Edwards & Sons Inc. in St. Louis. "The concern is that economic growth is going to collapse.''

"Stagflation is rearing its ugly head," said Peter Morici, a business professor at the University of Maryland. "The Fed faces a Hobson's choice: reining in inflation or tolerating unacceptable levels of unemployment."

At least Rex decided to put a little perspective on things:

For all the anxiety, however, growth in the first quarter was still close to or above trend, while inflation remained within the Fed's target. Growth has averaged 3.2% a quarter for the past 20 years...

"There is plenty of strength buried in the details," said Mat Johnson, chief economist for ThinkEquity Partners, noting the 20% growth in investment in information technology. "The pace of consumer spending growth remained high, despite the persistence of high energy prices."

In the same column, Steve Stanley makes the million dollar query:

"The big question is whether the economy is weakening on a trend basis or March was just another one-month soft patch," said Steve Stanley, chief economist for RBS Greenwich Capital, casting his vote for the temporary slowdown scenario.

"The problem appears to be the higher energy prices, and if energy prices stay elevated, the economy is going to struggle," Mark Zandi, chief economist of Economy.com told CBS Radio News. "If energy prices moderate, which I think at this point is still the most likely scenario, then the economy should have a reasonably good year."

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» Signs of the Times from Brad DeLong's Website
David Altig writes: macroblog: The GDP Report: We, Apparently, Are Not Pleased: I'm not sure I had ever contemplated what the day would look like when 3.1 percent growth was considered bad news, but now I know for sure... So much have our estimates of ... [Read More]

Tracked on Apr 28, 2005 11:37:55 PM

Comments

Consumption and investment demand increased but not as much as I would have hoped. OK, government purchases rose by very little but aren't we calling for fiscal restraint. But alas - with net exports getting even worse, private demand is not rising as fast as the fiscal restraint crowd would have hoped. I guess the lack of long-term fiscal credibility (as in my Rubinomics view of macro) is still dragging its heels for this economy. Yep - I tried to put a good spin on this, but I fell short.

3.1% is not bad. But will someone tell me please when the supply-side miracle kicks in? Corporations are sitting on tons of cash. The operative word is "sitting."
Even the energy companies are reluctant to invest.
Meanwhile, wages are stagnant, prices are up and savings are a joke.
A car can go 100mph on fumes for only so long.

It is helpful to know what you're talking about before making us read your stupid comments. Money growth has been slowing steadily for years. Job growth is virtually the same as any other post recession period. Try looking at a graph. Economics.com has a boatload of data for $50/year.

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April 27, 2005

Roach To Fed: J'Accuse! (The End)

My obsession concludes.

I may appear to have been a bit defensive in this series of posts. Perhaps it is so. But statements like this...

The Fed is not only hard at work in the engine room in keeping the magic alive with a super-accommodative monetary policy but is has also become the intellectual architect of the New Macro. Time and again, since Alan Greenspan rolled out his New Paradigm theory in the late 1990s, senior Federal Reserve policy makers have taken the lead role as proselytizers of a new macro spin that condones the saving, debt, property bubble, and current-account excesses of the Asset Economy.

... are just plain silly.

OK. I'll be generous and chalk that up to creative writing for effect. But a really constructive conversation would tackle these sorts of questions:

-- I gather the prescription favored by those who feel the same as Stephen Roach is for the Fed to be more aggressive in tightening policy. Fine, but is that what you really would have done in 1997, confronted with the circumstances at the time? In 1998? Would you have been impervious to the global financial stress I noted in the second post?

-- Would you choose to ignore the fact that employment growth in the U.S. has consistently struggled to gain traction? Would you be confident enough that bubbles exist, and that monetary policy can do something about them if they do, to tighten monetary policy if you had some concerns about the underlying strength of the real economy?

There is a reasonable debate to be had on all of these issues. Let's have it.

Did you gather that I didn't particularly care for the Roach column? Right. The critics, on the other hand, loved it: Resonance says "If you're into this topic, go read the whole thing"; The Housing Bubble bubbles "Mr. Roach is right on the mark again and the article is worth the few minutes it takes to read"; Bill Cara advises "I think you ought to be reading Stephen Roach’s daily commentary as I do"; The Cunning Realist claims "Stephen Roach, one of the few Wall Street pundits worth listening to, put out an excellent piece..."; James Wolcott agrees that, in that of which Roach speaks, "Fed chief Alan Greenspan has ignobly, disastrously, almost incomprehensibly failed"; The House of Cards endorses Wolcott; Moon of Alabama exclaims "Go read the whole piece, it provides more in-depth explanations of how the Fed has dug itself deeper at every turn, by inflating a new, bigger bubble whenever the previous one threatened to burst".

Comments

Defending Greenspan and Fedspeak after the fact with regard to consumer spending and further household debt accumulation is a bit much in my judgment. The effort was driven by low mortgage interest rates, home equity extraction, lack of substantial wage increases, and production of cheaper finished goods transferred overseas. The Fed wanted consumers to spend money. They did.

"I am not disputing the argument that current policy has contributed to higher asset prices, more household indebtedness, and strong activity in interest-sensitive sectors such as housing. But I am questioning the apparently firm conclusion of some that these developments represent distortions or imbalances that are likely to correct in an abrupt and harmful manner. At the very minimum, one cannot reach this conclusion with a great deal of confidence... Nonetheless, I cannot rule out the possibility that destabilizing imbalances are building."

"The rhetorical flourishes of America's central bankers have dug the US economy -- and by definition, a US-centric global economy -- into a deep hole. One bubble has since begotten another -- from equities to bonds to fixed income spread products (i.e., emerging market and high-yield debt) to property."

"When consumers hear from a Fed chairman that it makes little sense to take on fixed rate debt, they rush to floating rate instruments; not by coincidence, the adjustable rate portion of newly originated mortgage debt shot up in the immediate aftermath of Chairman Greenspan's comments on consumer indebtedness. And should asset-dependent, saving-short, overly indebted American consumers feel at risk if the Fed assures them that there is no housing bubble -- that the asset-based underpinnings of their decision making are well grounded? A record consumption share in the US economy -- 71% of GDP since 2002 versus a 67% norm over the 1975 to 2000 period -- speaks for itself."

"To the extent that equity extraction from ever-rising property appreciation was viewed as a substitute for organic sources of labor income generation, hard-pressed consumers went deeply into debt to monetize the windfall. As a result, household sector indebtedness surged to nearly 90% of US GDP -- an all-time record and up over 20 percentage points from levels in the mid-1990s when the Asset Economy was born. Secure in the asset-driven spending posture that resulted, consumers saw no need to save the old-fashioned way out of earned labor income. That's why the personal saving rate has collapsed and currently stands near zero."

"Fedspeak has taken us into the greatest moral hazard dilemma of all -- how to wean an asset-dependent system from unsustainably low real interest rates without bringing the entire House of Cards down."

"In short, without low real interest rates, the Asset Economy -- and all of its inherent imbalances and excesses -- is nothing."

Not to be overlooked, though...

Greenspan warning PENDING retirees at the last moment...after you have convinced them to risk everything else, including their homes.

"As a nation, we owe it to our retirees to promise only the benefits that can be delivered. If we have promised more than our economy has the ability to deliver to retirees without unduly diminishing real income gains of workers, as I fear we may have, we must recalibrate our public programs so that pending retirees have time to adjust through other channels. If we delay, the adjustments could be abrupt and painful. Because curbing benefits once bestowed has proved so difficult in the past, fiscal policymakers must be especially vigilant to create new benefits only when their sustainability under the most adverse projections is virtually ensured."

So, while the Fed was encouraging all forms of consumer spending and home equity extraction, it was also recommending that government support for social support program be downsized or curtailed. Greenspan has continued since August 2004 to call for the vast reduction in federal program benefits to citizens.

"The enormous wave of mortgage refinancing, which ended only in the fall of 2003, allowed homeowners both to take advantage of lower rates to reduce their monthly payments and, in many cases, to extract some of the built-up equity in their homes. In the aggregate, the cash flows associated with these two effects seem to have roughly offset each other, leaving the financial obligations ratio little changed."

"Indeed, the surge in cash-out mortgage refinancings likely improved rather than worsened the financial condition of the average homeowner. Some of the equity extracted through mortgage refinancing was used to pay down more-expensive, non-tax-deductible consumer debt or to make purchases that would otherwise have been financed by more-expensive and less tax-favored credit."

"In summary, although some broader macroeconomic measures of household debt quality do not paint as favorable a picture as do the data on loan delinquencies at commercial banks and thrifts, household finances appears to be in reasonably good shape."

"In addition, a significant decline in consumer incomes or house prices could quickly alter the outlook; nonetheless, both scenarios appear unlikely in the quarters immediately ahead. If lenders, including community bankers, continue their prudent lending practices, household financial conditions should be all the more likely to weather future challenges."

Greenspan message: Cash out home equity and pay off credit card debt. It's the thing to do. Keeping spending.

"An increase in household saving should also act to diminish borrowing from abroad. The growth of home mortgage debt has been the major contributor, at least in an accounting sense, to the decline in the personal saving rate in the United States from almost 6 percent in 1993 to its current level of 1 percent. The fall in U.S. interest rates since the early 1980s has supported both home price increases and, in recent years, an unprecedented rate of existing home turnover."

"This combination has led to a significant increase in home mortgage debt. The rise in home prices creates capital gains, which become realized with the subsequent sale of a home. The amount of debt paid off by the seller of an existing home averages about three-fifths of the mortgage debt taken on by the buyer, effectively converting to cash an amount of home equity close to the realized gain. This cash payout is financed by the net increase in debt on the purchased home, and hence on total mortgage debt outstanding."

"Even after accounting for the down payments on any subsequent home purchase, sellers receive, net, large amounts of cash, which they view as unencumbered. The counterpart of that cash, the increased debt taken on by the homebuyers, is supported by the new home values enhanced by capital gains. In addition, low mortgage interest rates have encouraged significant growth of home equity loan advances and cash-out refinancings, which are another channel for the extraction of previously unrealized capital gains on homes."

"All told, home mortgage debt, driven largely by equity extraction, has grown much more rapidly in the past five years than during the previous five years. Surveys suggest that approximately half of equity extraction shows up in additional household expenditures, reducing savings commensurately and thereby presumably contributing to the current account deficit."

"Interestingly, the change in U.S. home mortgage debt over the past half-century correlates significantly with our current account deficit. To be sure, correlation is not causation, and there have been many influences on both mortgage debt and the current account. Nevertheless, over the past two decades, major innovations in the United States have improved the availability and lowered the costs of home mortgages. These developments likely spurred homeowners to tap increasing home equity to finance consumer expenditures beyond home purchase. In contrast, mortgage debt is not so readily available among our trading partners as a vehicle to finance consumption expenditures."

Greenspan message: Consumers are extracting home equity to make other purchases. This is part of the reason why household savings are low. This contributes to the current account deficit.

We can go beyond a negative real federal funds rate to see signs of excessive monetary accomodation. For example, the significant credit growth as a % of GDP, the "search for yield" in emerging markets, the narrowing of spreads, and the run up in consumer debt, and the gap between the growth rate of the economy and the policy rate all at some level suggest monetary policy has been loose.

Roach is not singing solo on this issue. Other observers including The Economist and the IMF have also argued that the Fed has been too accommodative (See links below).

On a broader level, the loose U.S. monetary policy has been part of the excess global liquidity discussion. In fact, the Financial Stability Forum, whose participants included the Fed and other central bankers,called the excess global liquidity a risk:

"These [risks] included the current level of global funding and market liquidity and the associated low levels of risk premia and long-term interest rates." (see link below)

Strange that same central bankers who have significant influence over global liquidity are now concerned the level of it may pose a risk.

During the period in question, the U.S. has experienced above trend productivity growth. This alone implies the real rate should higher: higher marginal product of capital => higher real interest rate...unless of course the monetary authority has been intervening.

Consumer behavior is convincing evidence for a Fed policy of screwing savers to bail out debtors. When whipped savers become afraid to reach for higher risk and return, their last remaining alternative is capital flight.

Dear Movie Guy: If you only knew my world. Like Roach, you are fighting the last war. Greenspan is over, finished, done; he squandered his credibility. He was in the job too long.

Sure, Altig has some valid points. So does Roach, and so do you. But, it's now history. Most everyone agrees that the global economy is on a frightening trajectory, but few are offering any recommendations. Well?

There certainly is lots of blame to go around for the mess that has been created.

In the early 1990s, Ross Perot warned us about rising national debt and job losses from free trade. We tackled the national debt for most of that decade, but plunged into globalization and got our ass kicked. The problem is not with globalization but with the way it was implemented, allowing our current account to mushroom. Our politicians are to blame for not anticipating this.

Consumers have reacted by borrowing and running up 10 trillion $ in debt. This debt, which was growing by 8% per year in the late 1990s, is now growing by 11% per year. This is a national disaster with severe consequences yet to happen. I'll mostly blame the Fed for allowing this.

Investors are almost entirely to blame for the internet stock bubble, but the Fed should have put on the brakes to slow it down.

The British have an - remarkably amusing for non-native english speaker - expression for what is going on: Roach blew a gasket quite a while ago.

Having resisted the productivity acceleration thesis throughout the nineties, he finally succombed in the very late nineties (in the meantime he was calling for the USD to fall). The precise time when a few sane people where on the lookout for a downturn - national savings topped in the US in mid-1999, and some of us thought that might be important.

Once the recession started, he expected no end to it - all of this is DOCUMENTED ON THE RECORD -.

Now that that the expansion has been under way, he warns us all the time of policy mistakes: Mr. Greenspan is in the centre of his targeting range. I have no special interest in Mr Greenspan, and I am not old nor knowledgable enough to be able to compare him seriously with the Fed boss at the time of Roach's spell whithin the Fed. What I do know as a serious macro forecaster is that Mr. Roach has got it wrong (with hindsight, I do not pre-judge the future) for a long time indeed. There are several people in his team for whom I feel greater respect.

All of this is not to construed as a "defense" of Mr. Greenspan - he does not need me, obviously -. Where I do feel that Mr. Grenspan erred, is in his tacit approbation of a massive fiscal expansion that was decided - and this is crucial - even before the tragic events of 9/11. Of course, he gave qualifiers to his approval, but we all know, and he knows, that qualifiers are instantly forgotten by politicians and their spin-makers. He should have pointed out forcefully that projections of long-range future surpluses were extremely uncertain and should be dealt with as if they did not exist.

On the other hand - hey, I'm an economist -, I credit him and former President Clinton with a deal with the Clinton administration (tight budget, soft money) that proved admirable, and I also credit him and probably others with a deal in Asia that I called back in 2002 the "global convoy system". Unfortunately at that time, I had decent knowledge of Japan and the US, but did not insist properly on China's coming role in the system.

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Roach To Fed: J'Accuse! (III)

The Roach saga continues:

This whole story, in my view, remains balanced on the head of a pin of absurdly low real interest rates. And the Fed has certainly been pivotal in nurturing this low-interest-rate regime. In an extraordinary display of policy accommodation, the real federal funds rate is only now moving above the zero threshold after having spent three years in negative territory. Of course, a central bank has little choice to do otherwise if it has made a conscious decision to underwrite the Asset Economy.

In my view, Mr. Roach is making a classic mistake: Confusing a low federal funds rate with "an extraordinary display of policy accommodation." If I may, I will quote from myself:

A “neutral” monetary policy—one that avoids both inflationary and disinflationary pressures (as well as both artificial stimulus and unwarranted restraint on the pace of real economic activity)—requires that the funds rate target adjust to the evolving demand in credit markets as consumption, investment, and employment expand in anticipation of continued growth...

How far, and how fast, must the funds rate rise? What is neutral? It should be clear from this discussion that the answer is wholly dependent on economic developments well outside the scope of monetary policy. “Neutral” can only be defined relative to the state of the economy at a particular point in time. The economy of mid-2000 through mid-2003, characterized by distinct weakness in investment spending and employment growth, inevitably meant low real interest rates. Neutral in that situation meant a low—perhaps very low—funds rate to contain disinflationary pressures building in the economy.

Now, as the economy strengthens and investment and employment growth recover, the neutral setting of the funds rate is moving up. The distance it will go depends on myriad factors, most (if not all) of which will only be revealed in time (perhaps at a measured pace).

The suggestion that the low interest rates we have lived with over the past several years is proof of exceptionally stimulative policy is flat-out wrong. A corollary, of course, is that it is not generally possible to put a number on what "restrictive" is at any point in time. Hence, Roach predicts...

Given the excesses that now exist, it may even require a federal funds rate that needs to move into the restrictive zone -- possibly as high as 5.5%.

... and I, for one, would accept the proposition that 5.5% would be restrictive in the current environment. But I might also accept the proposition that something quite a bit lower than 5.5% would be restrictive. Or that if and when we get there, 5.5% will not be restrictive at all. After all, the funds rate was at 5.5% in the summer of 1997 when, according to Roach view of the world, policy was fueling the stock market bubble.

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Comments

David: You and I disagree about some things, but on monetary policy we seem to have broader agreement. I have trouble with some of what Greenspan has failed to do as watchdog of the public interest, but the Fed presidents and governors have been much tougher and have sounded alarms. Just yesterday I posted this from the president of the Cleveland Fed, which I thought was a remarkably strong statement to be made in public by a Fed official:

[Pianalto] also notes that the public can help the Federal Reserve with its job. She says “... it goes without saying that our job is made easier if the public expects that the fiscal authorities will address budgetary imbalances in a timely and effective fashion.”…

A large part of the point of my post was to note her call for public pressure to reign in the deficit. That cannot be construed as an enabling statement.

There are those who will say too little too late, and I haven't been completely happy with some of the lack of concern over the current account and federal deficits, but there is room for honest disagreement there.

By and large, the Fed has probably gotten it mostly right. I don't like having interest rates so low that you have no room to go lower if a really bad shock hits, it's a bit like going without insurance, but by and large I can't be overly critical of how they have operated. You are absolutely correct that the target MUST move, and right now I would argue that is moving upward (and perhaps more quickly than many realize because the AS shocks are being masked to some degree by positive AD shocks due to the deficit, but I wouldn’t push that too hard). I always hesitate to write that – I get called an inflation hawk, but I’m not, I’m an output stability hawk and that’s what it takes to get there. I just have to take more time to educate people about how the target moves over time and why it must be followed to avoid inflationary/deflationary policies and why that stabilizes output in the process, the real goal.

I challenge those who believe the Fe has made large mistakes to point to explicit negative consequences of Fed behavior. I've written about the failure to sound an alarm over the behavior of congress over the deficit/trust fund, and I believe rightfully so as watching out for the public interest is an important role of the Fed, but that's not something the Fed had direct control over and other than publicly denouncing such policy, they have little choice but to do their best in spite of poor policy elsewhere in government.

I don't want to tear down the entire Fed, it is a well-functioning institution. My displeasure is with Greenspan since January 2001 and other narrower issues. I don’t want anyone to confuse my displeasure with aspects of the Fed with a general indictment of its behavior. It has served us well, and will continue to do so as long as it maintains strict independence from other parts of government (but remember, the chair is an intentionally political position – that’s where the administration is allowed to have its say in Fed policy).

Well, it certainly seems no one among Greenspan's defenders is willing to touch the topic of the 'maestro's' push of adjustable mortgages. What gives?

Also, I think Roach's diatribe takes place within a political context, in which Roach has influence domestically that he doesn't have with the Asian Central Banks. The latter bear some responsibility for our housing bubble, as their financing of our deficits keeps long term interest rates lower than they would otherwise be. His anger, in other words, is a symptom of how our country has ceded control of our economic destiny.

Well, it certainly seems no one among Greenspan's defenders is willing to toudh the topic of the 'maestro's' push of adjustable mortgages. What gives?

Also, I think Roach's diatribe takes place within a political context, in which Roach has influence domestically that he doesn't have with the Asian Central Banks. The latter bear some responsibility for our housing bubble, as their financing of our deficits keeps long term interest rates lower than they would otherwise be. His anger, in other words, is a symptom of how our country has ceded control of our economic destiny.

You are right -- we broadly agree. And I encourage more discussion of the notion that the neutral policy rate is not a constant (or even a constant range). We can provide enough education on that point.

MG and Camille -- As I suggested in my response to Movie Guy's first comment on the topic, I was not intending to defend every word ever uttered by some Fed official. I still beleive, however, that that the weight of the comments coming from the FOMC participants has been pretty clear about concerns for imbalances in policy and some markets. But I sense that some people think any expression of optimism or calm is a violation of the public trust. That I can't buy.

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Roach To Fed: J'Accuse! (II)

Stephen Roach continues:

I am not a believer in conspiracy theories. But the Fed’s behavior since the late 1990s is starting to change my mind. It all began with Alan Greenspan’s worries over “irrational exuberance” on December 5, 1996, when a surging Dow Jones Industrial Average closed at 6437. The subsequent Fed tightening in March 1997 was aimed not only at the asset bubble itself, but at the impacts such excessive appreciation in equity markets were having on the real economy -- consumers and businesses alike. It was a classic example of the Fed playing the role of the tough guy... Unfortunately, the tough guys weren’t so tough after all. Predictably, there was a huge outcry on Capitol Hill as the Fed took aim on the US stock market. But rather than stay the course as an independent central bank should, the Fed ran for cover in the face of political criticism...

Do you think maybe, just maybe, the fact that CPI inflation was actually falling throughout 1997 might have had something to do with it? Or that perhaps the Asian currency crisis that began in summer 1997, continuing into summer 1998, followed by the collapse of the Russian ruble, the Long-Term Capital Management meltdown, and the collapse of the Brazilian real might have played some role in the course of policy over that period?

... the risks to the economy appeared to be strongly tilted toward rising inflation whose emergence would in turn threaten the sustainability of the expansion. Several members emphasized in this regard that a tightening move could be most effective if it were implemented preemptively, before inflation had time to gather upward momentum and become embedded in financial asset prices and in business and consumer decisionmaking.

There were, nonetheless, a number of reasons for delaying a tightening of policy. The behavior of inflation had been unexpectedly benign for an extended period of time for reasons that were not fully understood. Forecasts of an upturn in inflation were therefore subject to a considerable degree of uncertainty, and the expansion of economic activity could still slow to a noninflationary pace. Members also commented that a policy tightening was not anticipated at this time and such an action might therefore have unintended adverse effects on financial markets. Members recognized that from the standpoint of the level of real short-term interest rates, monetary policy could already be deemed to be fairly restrictive.

The current momentum of the expansion, together with broadly supportive financial conditions and favorable business and consumer sentiment, suggested that economic growth was likely to be well maintained, especially over the nearer term. As a consequence, the members agreed that there remained a clear risk of additional pressures on already tight resources and ultimately on prices that could well need to be curbed by tighter monetary policy. But the members also focused on two important influences that were injecting new uncertainties into this outlook. Turmoil in Asian financial markets and economies would tend to damp output and prices in the United States. To date, it appeared that the effects on the U.S. economy would be quite limited, but the ultimate extent of the adjustment in Asia was unknown, as was its spillover to global financial markets and to the economies of nations that were important U.S. trading partners.

By the July 1998 FOMC meeting, the Asian crisis was an explicit driver of the Committee's interest-rate decision:

[An] important reason for deferring any policy action was that a tightening move would involve the risk of outsized reactions and consequent destabilizing effects on financial markets in the growing number of countries abroad that were experiencing severe financial difficulties. It was not possible to anticipate precisely what those effects might be, but the risks seemed to be particularly high at this time. To be sure, U.S. monetary policy had to be set ultimately on the basis of the needs of the U.S. economy, but recognition had to be given to the feedback of developments abroad on the domestic economy. Those repercussions could be quite severe in the event of further sizable economic and financial disturbances in some of the nation's important trading partners. Many members concluded that because there did not seem to be any urgency to tighten current policy for domestic reasons, given the likelihood that inflation would remain subdued for a while, important weight should be given to potential reactions abroad.

As we now know, things did not soon improve, and the next moves would be to cut the funds rate (ironically just at the time that the benign inflation performance we had been enjoying was coming to an end).

Is it that unreasonable to accept that the FOMC might have been inclined to forgo raising the funds rate in 1997 because the 12-month CPI inflation was falling (from over 3% to under 2%)? Would Mr. Roach have us believe that restraining the supply of the world's reserve currency would have been the correct response to severe distress in global financial markets? Should a reasonable person attach him or herself to Oliver-Stonesque conspiracy theories instead of the straightforward explanations of the actual decisionmakers?

Yet more to come.

P.S. for the economists: Plug the inflation rate and almost any reasonable assumption of the output gap in 1997 into your favorite version of the Taylor rule. I think you'll find that, by this measure, monetary policy does not appear to be particularly "easy."

I think you are indicating a preference for limited monetary creation via a fairly strict commodity standard? That remains an interesting question. Do we have a global fiat monetary system because the gold standard was truly not optimal, or simply because governments could not help themselves? In any case, a true commitment to price stability ought to more or less deliver the benefits of commodity money system. Without that anchor, of course, mistakes will be made, and those mistakes will impose costs. But the gold standard had its costs as well -- we just don't call them mistakes because the problems are not directly driven by an easily identifiable hand on the monetary levers.

MG -- I think everyone agrees that the priority of the Fed is the US economy. If you look at the comments of the participants you will find that global financial conditions were a concern precisely due to fears about negative feedback on the US economy.

Altig said: Plug the inflation rate and almost any reasonable assumption of the output gap in 1997 into your favorite version of the Taylor rule. I think you'll find that, by this measure, monetary policy does not appear to be particularly "easy."

True, and in 1998 rates were even more out of line with respect to a Taylor rule.

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In all my years in this business, never before have I seen a central bank attempt to spin the debate as America's Federal Reserve has over the past six or seven years...

... senior Federal Reserve policy makers have taken the lead role as proselytizers of a new macro spin that condones the saving, debt, property bubble, and current-account excesses of the Asset Economy.

Of course, Mr. Roach offers plenty of examples of Fed officials making wild, wacky, throw-caution-to-the-wind statements like this one from Mr. Greenspan:

Although I scarcely wish to downplay the threats to the U.S. economy from increased debt leverage of any type, ratios of household debt to income appear to imply somewhat more stress than is likely to be the case. For at least a half century, household debt has been rising faster than income, as ever-higher levels of discretionary income have increased the proportion of income spent on assets partially financed with debt.

The pace has been especially brisk in the past two years as existing home turnover and home price increase, the key determinants of home mortgage debt growth, have been particularly elevated. Most analysts, even those who do not foresee a mounting bubble, anticipate a slowdown in both home sales and the rate of price increase...

To be sure, some households are stretched to their limits. The persistently elevated bankruptcy rate remains a concern, as it indicates pockets of distress in the household sector. But the vast majority appear able to calibrate their borrowing and spending to minimize financial difficulties. Thus, short of a significant fall in overall household income or in home prices, debt servicing is unlikely to become destabilizing...

In summary, although some broader macroeconomic measures of household debt quality do not paint as favorable a picture as do the data on loan delinquencies at commercial banks and thrifts, household finances appears to be in reasonably good shape. There are, however, pockets of severe stress within the household sector that remain a concern and we need to be mindful of the difficulties these households face.

In addition, a significant decline in consumer incomes or house prices could quickly alter the outlook; nonetheless, both scenarios appear unlikely in the quarters immediately ahead. If lenders, including community bankers, continue their prudent lending practices, household financial conditions should be all the more likely to weather future challenges.

Some observers worry that recent Federal Reserve policy, by keeping short-term rates at very low levels for an extended period, has encouraged investors to "reach for yield"--that is, to shift their portfolios toward riskier and longer-term securities, which generally have higher yields, to keep realized returns from falling. They also worry about the effects of a related behavior in which financial intermediaries borrow at low short-term rates to lend at higher long-term rates--the so-called "carry trade"--and about the effects of low interest rates on the prices of houses. To a considerable extent, these processes are part of the efficient functioning of markets... The issue is whether this process has gone too far--that is, whether investors are failing to take adequate account of the risks of those alternative investments. Forming such a judgment requires a view on the level of asset prices that would be "appropriate" given economic fundamentals. Unfortunately, economists are not very good at this, but neither is anyone else, including Wall Street analysts...

Warnings about a possible "bubble" in house prices have been sounded for a number of years now. About a year ago, I examined this issue in some detail and concluded that, while one could never be very confident about such a judgment, house prices were not obviously too high and the housing stock was not clearly too large. Since then, however, prices have climbed further, and by more than the rise in rents--a proxy for the return on houses. Consequently, the odds have risen that these prices could be out of line with fundamentals. We still cannot be very confident about whether a significant misalignment exists, however...

In the absence of any substantial distortions in asset prices and debt levels, households and businesses, on average, have not likely been engaging in misguided decisions that they, or the central bank, will come to regret. Nevertheless, as emphasized above, policymakers face a tremendous amount of uncertainty regarding this judgment... Because they cannot rule out the chance that some asset prices might correct more than anticipated, policymakers must consider how the economy might withstand such a correction...

I am not disputing the argument that current policy has contributed to higher asset prices, more household indebtedness, and strong activity in interest-sensitive sectors such as housing. But I am questioning the apparently firm conclusion of some that these developments represent distortions or imbalances that are likely to correct in an abrupt and harmful manner. At the very minimum, one cannot reach this conclusion with a great deal of confidence... Nonetheless, I cannot rule out the possibility that destabilizing imbalances are building.

I would attempt to pull appropriate passages from the recent speeches by Greenspan, by Kohn, and by Governor Roger Ferguson that Roach proclaims "a veritable broadside against the time-honored notion of the current-account adjustment," but I don't have the first clue what he is talking about. Ferguson's speech for example -- a quick summary is here -- is essentially a textbook breakdown of various sources of current account deficits. His crime appears to be that he agrees with Ben Bernanke's (admittedly provocative, but far from heretical) suggestion that restoring fiscal balance in the U.S. may not be enough to substantially reverse our current account deficit.

Is this what counts as "macro spin that condones the saving, debt, property bubble, and current-account excesses of the Asset Economy"? Are we to believe that any expression of confidence that the landing will be soft, no matter how qualified, is an act of corruption?

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I'm looking forward to part II. I thought Kohn's speech was very good (as were some of the others that you linked).

But I do have a problem with some of Chairman Greenspan's comments over the last few years. When Mr. Greenspan starts a speech with "I want to emphasize that I speak for myself", I always cringe. Oh well, I guess he is entitled to his personal opinion, but most people don't realize Mr. Greenspan has a terrible record of economic predictions (away from monetary policy).

I have been a long time reader of Roach. His points over the years have in some ways always been viewed by the market as wrong. But, when you look at the equities market return since the 1998 low and subtract out dollar depreciation....well, maybe he is right. Alot of what his recent Fed bashing is about what has occurred since LTCM. The negative effects of easy money have not been felt by the economy as of yet. only the good times. Homeownership in the US is running north of 65%. This is getting to be "full employment" of the housing sector. The cash out refi game has only made new risks. He stresses lack of wage gains consistently. This is true. Wages cannot grow 2% while housing cost rise by 10%. The math doesnt work. The "Asset Economy" as he calls it is real. The recent tuff talk by the Fed is to save face. The damage has been done. If the foreign CBs feel the Fed is not in control they will simply raise rates themselves. Lets hope everything Roach says does not become true. I told you so would not be good.

I can appreciate your frustration. But do you really want to defend Greenspan's remarks on switching to variable interest rate loans? Come on, I heard him. It was a Kodak moment of which I observed, "He didn't really mean that, did he? Good grief!"

Once Greenspan suggested that consumers should consider switching to variable interest rate mortgages, that was the last straw for me. Simply, Greenspan crossed the line. He was no longer trying to help consumers reduce their debt load. He was promoting a vehicle that would extract more consumer spending in support of the general economy. But he was putting the American households at risk with such advice. Those who acted on his recommendation are headed for big trouble.

While I am of the judgment that Greenspan bounced back and forth on a few key subjects during some of his Congressional testimony, I will focus on Stephen Roach's point about consumer spending driven by accommodation.

My first round of remarks will be posted under your fourth post, Roach To Fed: J'Accuse! (The End).

Your four posts could create one of the best discussions among the econ blogs.

I think the fed did a pretty good job of getting us out of recession. We suffered a huge market shock and there was a brief and shallow recession and I think aggressively cutting interest rates was a big part of the solution. Of course, doing this wasn't risk free. But at the time, if given two options a) shallow recession with property bubble and larger current account deficit or b) deep, long recession with possible risk of depression, but no more bubbles and less imports, most people would choose a. Even though b would likely be better in the long term.

The fed has become a political organization. Ideally, this would not be the case, but because there are many more investors managing their own portfolios than in the past, there are a lot more people (more voters) tuned to what the fed does. The past two presidential elections have been very close and bad comments from the fed can hurt the economy enough to swing an election.

Having said that, I tend to agree with Roach on his diatribes about our unsustainable world economy. Since Bush doesn't need to worry about re-election, maybe now would be a good time, politically, for the fed to drop the hammer and jack up rates. The risk here is if short term rates go up and long term rates remain stuck in the 4's.

Do I want to defend Mr. Greenspan's decision to offer specific investment advice? Nope -- no comment on that one.

Charlie -- In some sense, of course, the Fed is by nature a political institution, in the sense that is a creation of Congress and is ultimately accountable to the people through Congress. But I suspect you mean "political institution" in the sense of partisan. I can only tell you my own personal perspective, and that is that the Fed in my experience is about as nonpartisan as a public institution can possibly be. That doesn't mean there aren't mistakes -- and my posts were not intended to make any such claim. What I'm arguing is that I beleive what mistakes have been mad have been honest ones.

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April 26, 2005

In The News Today

Purchases rose 12.2 percent to a 1.431 million annual rate in March following a 1.275 million pace in February, the Commerce Department said today in Washington...

The median price fell to $212,300 in March from $234,100 a month earlier. Compared with the same month last year, the median price is up 1.3 percent.

which elicited this response from GTD:

I have looked through the past median price data and am less convinced the price drop means anything. I have a natural contrarian reaction when I read the word "record" relating to monthly % changes though. The better interpretation is probably that if the U.S. consumer is hitting some sort of wall it has not showed up in housing data yet.

Further news of the expanding recovery in Europe, following up on the IFO german survey released a few days ago.

INSEE, the French statistical institute, reported today the results of its monthly survey of manufacturing opinion. The synthetic indicator fell from 101 to 97 in April.

Opinion on general prospects for the economy fell to -18 from an average - 4 during the first quarter of 2005.

Opinion on own prospects kept falling as well to +2 from +6 in March. They have been falling since December was the figure was +15. Inventories are judged heavy, orders are low, etc...Numbers such as these usually suggest something serious in the making.

French officials, who face a difficult referendum on May 29th, maintained forecasts of 2% to 2.5% GDP growth in 2005.

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Do Americans Support Privatization?

Mark Thoma gives the heads-up on Congressional hearings on the subject that begin today, noting this bad-sounding piece of news for the administration.

And despite the president's efforts to rally support for his Social Security plan, seven in ten Americans say they're uneasy about his approach to the issue.

More people (49 percent) say the president's plan to partially privatize the system is a bad idea than say it's a good idea (45 percent).

There is certainly news there about confidence in whatever the public perceives the adminstration's plan to be, but I'm not sure how much we learn about attitudes concerning privatization per se. Is it not possible that one could be a proponent of reforms that include privatized accounts and still be profoundly uneasy about the administration's approach?

Paul Krugman, of course, thinks he's got it figured out. In yesterday's column, to which Mark links, Krugman starts with the results from a Gallup poll question on the general state of the economy, throws in a little Terry Schaivo and Tom Delay red (er, blue) meat, before finally moving to the (ambiguous) CBS poll question and somehow concluding that the evil Bushies and their minions are about to shove privatization down the throats of a resistant public.

-- 56% of respondents favored reform that included some provision for private accounts invested in the stock market-- 58% of respondents favored legislation that would allow people who retire in future decades to invest some of their Social Security taxes in the stock market and bonds-- 51% of respondents felt it was necessary to make changes to Social Security this year-- a slim majority -- 50% vs. 46% -- responded that they relying on the current system to delivered promised benefits was riskier than investing in stocks and bonds-- A significant majority favored limiting benefits to wealthy retirees and eliminating the cap on wages subject to taxation as ways to address concerns about Social Security

... affluent Americans are split on the merits of Social Security overhaul, although about 45% of respondents believe that this move could boost stock-market returns...

[The April UBS/Gallup survey of investors] showed similar results, with 50% saying that the Social Security system should be kept as is, and 47% opting for personal savings accounts. This is the first time since June 2000 -- when respondents were first asked about their support for Social Security overhaul -- that more people preferred the status quo.

Do Americans support privatization? Who knows? I think what we are seeing in all these survey results is good old-fashioned common sense. I'd bet that most Americans think some sort of privatized account option is a good thing, recognize that there is no free lunch, and know that the devil lives comfortably in the details.

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» Social Security Debate Degeneration from The Dead Parrot Society
President Bush's recent campaign stop in Galveston, Texas, was a public relations disaster. Years ago, the President's Social Security Commission articulated a Social Security reform that (a) increased benefits to the poorest of the poor, (b) increased... [Read More]

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Comments

I'm not opposed to some reforms and would give a partial thumbs up to the suggestions from Tyler Cowen. And I have never had a beef with Robert Barro who used to advocate complete privatization. While I don't, I enjoy his intellectual honesty. I also enjoy yours, which was the real reason I posted all that Cato free lunch dreck. Some Angrybear readers incorrectly suggested honest conservative was an oxymoron. One reader thought that I lumped you into the free lunch crowd - to which I had to say that was never my intent. Fester was the one who got it right - there are honest conservatives like you and Barro who really should have their views, which are very different from the likes of Michael Tanner, heard. Thanks for this post and the opportunity to be more clear what I was trying to say yesterday. We economists really do need to step up and get these issues above the usual partisan nonsense.

For me, the issue has always been the way risk is handled, not the involvement of equities as a means of storing the surplus.

We can give everyone the mean return if risk is held collectively. Under the proposal, risk is held invidually and I see no need for that. Why not average over individuals so that there are no big winners and more importantly, no big losers? I suppose there is some sort of private propoerty individual reponsibility argument here, but as I see it the shocks that social insurance mitigates are not related to individual behavior (except through markeet failure mechanisms such as moral hazard).

I wonder if those being polled understand this difference? I would have preferred that back in 2001 the trust fund assets were channeled through intermediaries into the private market as a means of storing the surplus (annd we'd have more national saving...), taking advantage of returns on equities, and sharing the risk collectively. If that had happened, things would look far different today. But of course the objection was that the government would then be invlolved in the private market on too large a scale. I don't buy that and don't see how borrowing rather than lending trillions to the private sector makes a difference.

What's to stop people from getting the mean return now? There is absolutely nothing to keep people from purchasing indexed-based mutual funds. Unless, of course, they do not have the funds to do so, in which case your proposal gives them access. But that's privatization!

As for having the government as the intermediary, I thought one of Brad Delong's objections to privatization has been that the government -- or at least the current administration -- would mess things up. Does putting them in charge of a giant private capital allocation scheme meet the comfort test?

David - you just made my point, which is also the point being made by Barro and Becker. Yes, households have Soc. Sec. retirement benefits AND 401(K)s and if they wanted more expected return (along with the extra risk), they could just convert 401(K) bonds into stocks. Bush's privatization is not going to change overall asset allocation, which means NO FREE LUNCH! Glad we agree!

First, I want to carefully distinguish between the saving and the insurance component of retirement income. People can take as much risk as they desire, etc. with the savings component. My comments are limited to the insurance component.

I will take as given a societally determined minimum level of support for the elderly – anything below this and we help them. That is what the insurance against economic risk is for, insuring against falling below this minimum level.

Any risk around this mean at all risks having some individuals fall below the minimum acceptable level and their incomes will need to be augmented by everyone else – an income transfer system that many on the right disdain so much.

So, as I see it, the only acceptable level of risk around the insurance value is zero to avoid such transfers, and to avoid moral hazard behavior it needs to be governmentally regulated. How is perfect risk accomplished in the markets you suggest – index funds and the like – by creating a perfect hedge and duplicating the T-Bill rate.

Why go to all the trouble, pay all the transactions costs and fees to create a perfect hedge, when T-Bills and money market funds already exist?

Think of it this way. How does shifting financial risk to individuals help them insure against economic risk around the minimum level? It doesn’t.

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The national median home price jumped 11.4 percent to $195,000 from the same month a year ago, the NAR report showed. That price increase was the biggest since December 1980, when prices rose 11.5 percent, NAR said.

"The market is very strong," said NAR Chief Economist David Lereah. "The problem in this country is housing supply. It's still very lean."

In March, the supply of homes for sale at the current pace was 4 months' worth, down from 4.2 months' worth in February.

"We still have this awkward balance between demand and supply," Lereah said.

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